Volunteers and Their Responsibilities for Trust Fund Taxes

By Scott R. Fouch

E-mail Story Print Story

Statutory Framework

The amounts collected from employees’ wages are considered to be held by the employer in trust for the United States [IRC section 7501(a)]. Once withheld, the employee receives credit from the IRS regardless of whether the amount is ever remitted to the government [Treasury Regulations section 1.31-1(a)]. In situations where withholding taxes are not paid over to the government by the employer, the IRS may seek collection from any person within the organization who is responsible for the collection, truthful accounting for, and payment of the trust fund taxes, and who willfully failed to remit the taxes to the government [IRC section 6672(a)].

With respect to tax-exempt organizations, the penalty will not be assessed against an unpaid voluntary board member as long as the individual: 1) is serving solely in an honorary capacity; 2) does not participate in the daily financial operations of the organization; and 3) does not have knowledge of the failure of the payment of the tax. The preceding will not apply, however, if it results in no person within the organization being liable for the penalty [IRC section 6672(e)].

If a volunteer within a tax-exempt organization cannot meet the requirements of IRC section 6672(e), or if the individual serves as an outside director on the board of a taxable corporation, then the IRS may assess the penalty if two criteria are met:

• The individual must be required to collect, truthfully account for, and pay over the tax. Such an individual is commonly referred to as a “responsible person” [Slodov v. U.S., 78-1 USTC para. 9447 (USSC 1978)].
• It must be established that the person “willfully” failed to collect, account for, or pay over the tax owed.

Who Is a ‘Responsible Person’

Because neither the IRC nor the Treasury Regulations define who is considered a responsible person, the interpretation has been left up to the courts, which have taken a very broad view of the issue. A responsible person has been described as an individual who:

• Possesses the effective power to pay the tax [Howard v. U.S., 83-2 USTC para. 9528 (CA-5, 1983)];
• Exerts significant control over the company’s finances or general decision-making [Hochstein v. U. S., 90-1 USTC para. 50,205 (CA-2, 1990)]; or
• Controls disbursements of funds and the priority of payments to creditors in preference of withholding obligations [Gephart, 87-1 USTC para. 9319 (CA-6, 1987)].

In making this determination, the courts attempt to balance all of the facts and circumstances surrounding an individual’s authority within the company. Specific factors held to be relevant are whether the individual: 1) is an officer or member of the board of directors; 2) owns shares or possesses an entrepreneurial stake in the company; 3) is active in the management of day-to-day affairs of the company; 4) has the ability to hire and fire employees; 5) makes decisions regarding which, when, and in what order outstanding debts or taxes will be paid; 6) exercises control over daily bank accounts and disbursement records; and 7) has check-signing authority [Thomas v. U.S., 94-2 USTC para. 50,607 (CA-7, 1994)].

Two other important points should be kept in mind:

• No single factor above will cause an individual to be classified as a responsible person. The courts attempt to determine whether the person was connected closely enough with the business to prevent the nonpayment of tax from occurring [Bowlen v. U.S., 92-1 USTC para. 50,098 (CA-7, 1992)].
• Significant control does not mean exclusive control [Mazo v. U.S., 79-1 USTC para. 9284 (CA-5, 1979)] or absolute control (Gephart).

As such, there can be several responsible persons within the company. For example, in Carter v. U.S. [89-2 USTC para. 9446 (S.D. N.Y., 1989)], the taxpayers were officers and directors of a not-for-profit corporation. The minutes of board meetings indicated that the directors were involved in routine business concerns such as corporate funding, bookkeeping, salaries, and the hiring and firing of employees. The directors had check-signing authority and invoices were attached to checks presented to the board for approval. Payroll checks were prepared by the City of New York as a condition to city funding, using a facsimile signature.

The directors argued that they became involved in corporate business only when high-level employees were concerned. However, the board minutes showed that the board dealt with such routine matters as the hiring of a secretary/receptionist, the work performed by the data clerk-typist, the conditions of the books and records, and the corporation’s tax problems. Given this level of involvement by the directors in the day-to-day activities of the corporation, the court ruled that all of them were responsible persons.

Defenses to Responsible Person Classification

Lacks the authority to pay the delinquent taxes. As noted earlier, in determining who is considered to be a responsible person, the courts attempt to balance the facts and circumstances surrounding an individual’s authority within the company to pay the taxes. The Federal Circuit Court of Appeals addressed this issue with respect to unpaid outside directors in Godfrey v. U.S. [84-2 USTC para. 9974 (CA-FC, 1984)].

Godfrey was the chairman of the board of a taxable corporation that was experiencing significant financial difficulty. He was not authorized to sign checks, received no salary as chairman, played no role in the preparation of the company’s payroll, and never signed any payroll forms. As a director, Godfrey participated in electing officers, hired or approved the hiring of top-level consultants, and authorized the borrowing by officers on behalf of the corporation. He was also instrumental in negotiating a critical recapitalization agreement with a potential investor.

The trial court had held that Godfrey’s status as chairman, and the respect and deference accorded that status, amounted to the ultimate authority to control the payment of withholding taxes, and resulted in Godfrey being considered a responsible person for purposes of IRC section 6672. Reversing on appeal, the Federal Circuit Court of Appeals observed that there had never been a case where an outside director of a publicly held corporation had been held to be a responsible person who: 1) neither signed nor had authority to sign checks, 2) did not participate in the day-to-day fiscal management of the corporation, 3) did not control the payroll, 4) did not determine which creditors would be paid, and 5) did not own a significant fraction of the company’s voting stock.

Although it was an important consideration that Godfrey was the most important individual in the business affairs of the company, it was not sufficient to make him a responsible person. The crucial inquiry required by the statute was whether Godfrey held the substantive power to compel or prohibit the allocation of corporate funds with respect to the trust fund taxes. Given that no evidence was provided that Godfrey had exercised control of the collection, accounting for, and payment of the trust fund taxes, the court ruled that he was not a responsible person. The court also noted that knowledge of nonpayment of the taxes was a factor used to determine willfulness but was irrelevant in considering the question of whether he was a responsible person.

The Taxpayer Bill of Rights 2 (P.L. 104-168), which added subsection 6662(e) in 1997, addressed the “authority to pay” issue for volunteers to tax-exempt organizations. In what appears to be intended as a safe harbor provision, a volunteer will not be considered to have the authority to pay withholding taxes if the volunteer’s position is solely honorary and the volunteer is not involved in the company’s day-to-day operations. These criteria were specifically addressed in Holmes v. U.S. [2004-2 USTC para. 50,301 (S.D. Tex., 2004)].

The taxpayer in question, Holmes, was an unpaid director and chairman of the board of a parochial school that was experiencing financial difficulties. All school checks required two signatures. Holmes, Floyd (another director), and the school’s administrator were signatories. Holmes claimed that he signed checks only when others were unavailable. When Holmes discovered that the withholding taxes had not been paid, he suggested cutbacks to free up the necessary funds. Holmes claimed that the board rejected his ideas at the insistence of the school’s administrator.

The court concluded that Holmes had enough authority within the school to be considered a responsible person. He knew of the unpaid taxes and he signed several checks to some of the school’s creditors instead of paying the withheld taxes. The court further stated that Holmes was not immune from liability because he was a volunteer for the school. His titles, positions, and jobs were not honorary, and he was involved in the school’s financial operations.

In light of Holmes, it is likely that most board positions for tax-exempt organizations would not be considered honorary by the courts. The duties and responsibilities of the board members, and especially of a treasurer, are generally outlined in detail in an organization’s bylaws. Thus, the safe harbor would appear to be of little value.

Delegation of authority. Taxpayers have also attempted to avoid responsible person classification by asserting that another individual within the company had been directed to pay the tax. The courts have generally ruled, however, that if an individual had sufficient authority in the company such that the tax delinquency could have been avoided, delegation of responsibility will not relieve an otherwise responsible person of liability [e.g., Thomsen v. U.S., 89-2 USTC para. 9575 (CA-1, 1989)].

In Wright v. U.S. [96-1 USTC para. 50,114 (E.D. N.Y., 1996)], the chairman of the board of directors of a not-for-profit organization attempted to avoid responsible person classification by claiming to have delegated it to the executive director and the in-house accountant. Wright, an unpaid volunteer to the organization, had express authority to sign checks and tax returns, sign loans, approve use of the organization’s funds, and terminate the executive director. Although authority to oversee the preparation of tax returns, the keeping of records, the payment of wages, and the withholding and payment of taxes rested with the board, the duties were delegated to the executive director and the accountant.

The court ruled that the law does not permit individuals to delegate their authority to another person within the organization and blindly trust that the duties will be carried out. Wright was entrusted with the duty to make sure that the organization’s funds were properly spent and that its financial and tax obligations were met. The signing of checks and loan documents inserted him into the organization’s day-to-day operations. Wright’s position on the board was much more than honorary.

Orders from higher authority—control of funds. Another argument that has been used by taxpayers in an attempt to avoid the penalty is that they lacked authority because they were ordered not to pay the taxes by an individual with greater authority within the organization (i.e., they were not in control of the funds).

In Howard, the taxpayer served as director, minority shareholder, and executive vice president of the corporation. Howard also managed the corporation’s day-to-day operations. During a period of financial difficulty, the president, who was also the majority stockholder of the corporation, instructed Howard not to pay the withholding taxes to the government.

The court recognized the quandary facing Howard. If he had paid the taxes, thus fulfilling his obligation to the government, he would have been fired. An unsympathetic court noted that: “Faced with the possibility of leaving the frying pan with only minor burns, the taxpayer chose instead to stay on in the vain hope of avoiding the fire. While we appreciate the difficulty of his position, we cannot condone his abdication of the responsibility imposed upon him by law.” Howard was held liable for the unpaid taxes.

Similar decisions were reached in Gephart, Roth v. United States [86-1 USTC para. 9172 (CA-11, 1986)], Lubetzky v. U.S. [2005-1 USTC para. 50,207 (CA-1, 2005)], and Brounstein v. U.S. [93-2 USTC para. 50,512 (CA-3, 1992)]. Although the previous court decisions are very troubling for taxpayers facing orders from someone of higher authority within the organization, the Tenth Circuit Court of Appeals has taken a potentially more favorable view. In Jay v. United States [89-1 USTC para. 9154 (CA-10, 1989)], the court held it was possible that a supervisor’s control over an employee’s actions might be sufficient to render that employee not a responsible person. According to the Tenth Circuit, the critical factor is to determine whether the person possesses a sufficient degree of authority over corporate decision-making.

Graunke v. United States [89-2 USTC para. 9449 (N.D.Ill.)] applies the Tenth Circuit’s rationale in ruling that the taxpayer was not a responsible person. In Graunke, the taxpayer, who had completed two years of business college, was assessed a responsible person penalty by the IRS. Graunke had completed nine quarterly federal withholding tax returns (Form 941) during the period in question. He signed three of the returns; five were signed by the owner of the company, and one was left blank. On one of the returns, Graunke indicated his title was “comptroller.”

Graunke had check-signing authority on the company’s bank account, but several employees testified that the owner decided which creditors would be paid. It was clear from the records that there was never enough money to pay all creditors, meet the payroll, and pay withholding taxes. Graunke spent two days a week at the company and was not in charge of day-to-day operations.

Graunke warned the owner of the liability for withholding taxes. The owner indicated that he intended to obtain a loan on his motel properties to pay the withholding taxes and that Graunke should not pay them until the financing was completed. After realizing that new financing had not been obtained, Graunke refused to sign the tax returns.

The owner testified at trial that he was responsible for the failure to remit federal withholding taxes and that all financial and employment decisions were his responsibility. The company’s CPA also testified that the owner made all the financial decisions and decided who would and would not be paid by his business.

The District Court ruled that Graunke was not a responsible person within the meaning of IRC section 6672. Basing its decision on Jay, the court stated that it did not appear that the law has gone so far as to require that a person must disregard check-writing instructions in order to avoid liability. Rather, the focal point should be whether the taxpayer “possessed a sufficient degree of authority over corporate decision-making to make him a responsible person.” The evidence in Graunke showed that the owner made all financial decisions and strictly controlled the payment of creditors. There was no evidence that Graunke could have or would have, in the short time he was employed, overridden the owner’s payment decisions. Also unclear was whether Graunke was even aware of how the financial matters would be conducted. Graunke’s only responsibilities were accounting matters and bill-paying at the direction of the owner.

Although Graunke was not in a not-for-profit setting, treasurers or voluntary bookkeepers could potentially face the same type of pressure from a not-for-profit entity’s board or chairman. The Graunke decision may serve as some comfort to these volunteers. However, it should be noted that had Graunke lived outside of the Tenth Circuit’s jurisdiction, it is probable that the IRS would have prevailed.

Determining Willfulness

The second criterion for assessment of the responsible person penalty is that the individual’s failure to ensure that withholding taxes were remitted must have been willful. The willfulness criterion has been described as a “voluntary, conscious and intentional decision to prefer other creditors over the Government” [Burden v. U.S., 73-2 USTC para. 9547 (CA-10, 1973)]. Willfulness in this context requires only that the responsible person knew that the company was required to pay withholding taxes and that company funds were being used for other purposes [e.g., U.S. v. Rem, 94-2 USTC para. 50,357 (CA-2, 1994)]. The IRS is not required to establish that the person deliberately sought to defraud the government (Thomas).

There are a number of defenses that a taxpayer can raise with regard to the willfulness criterion that have met with varying success in court:

Reasonable cause. Taxpayers have often argued that the willfulness criterion has not been met due to extenuating circumstances that resulted in the nonpayment of the trust fund taxes. Seven circuit courts of appeal have held that the reasonable-cause exception is not valid. Any payment to other creditors, including the payment of net wages to the corporation’s employees, that is made with knowledge that employment taxes are due and owing to the government, constitutes a willful failure to pay taxes as a matter of law [e.g., Monday v. U.S., 70-1 USTC para. 9205 (CA-7, 1970)]. It is no defense that the corporation was in financial distress and that funds were spent to keep the corporation in business with an expectation that enough revenue would later become available to pay the government [Emshwiller v. United States, 77-2 USTC para. 9744 (CA-8, 1977)]. Nor is it a defense that a taxpayer would be terminated if he signed a check to the IRS without the express authority of a superior (Gephart).

Three courts have held that in very limited circumstances, reasonable cause may be used as a defense against willfulness. The Tenth Circuit Court of Appeals provides that the reasonable-cause exception may apply if the taxpayer can prove that reasonable efforts were made to protect the trust fund taxes but those efforts were frustrated by circumstances outside of the taxpayer’s control [Finley v. U.S., 97-2 USTC para. 50,613 (CA-10, 1997)]. Unfortunately, there are no cases of widespread application where the reasonable-cause exception has been met. Factors not meeting reasonable-cause criteria include:

• The delegation of the responsibility to another person [Lawrence v. U.S., 69-1 USTC para. 9392 (N.D. Tex., 1969)];
• The expectation that the financial condition of the company would improve [Paisner v. O’Connell, 62-2 USTC para. 15,439 (D.R.I., 1962)];
• The assumption that the government would satisfy its tax claims out of another fund [Cash v. IRS, 65-1 USTC para. 9428 (CA-5, 1965)];
• The reliance on statements prepared by the accountants [Newsome v. U.S., 70-2 USTC para. 9504 (CA-5, 1970)]; and
• The taxpayer’s misunderstanding of the legal withholding requirements [Sorenson v. U.S., 75-2 USTC para. 9694 (CA-9, 1975)].

Lack of knowledge. Another defense that has been used against the willfulness criterion is that the person was unaware the tax had not been remitted by the company. Although the IRS has generally taken the position that knowledge of nonpayment is irrelevant, the courts have consistently held that when the taxpayer believed that payment had been made, the willfulness criterion had not been met [e.g., U.S. v. Leuschner, 64-2 USTC para. 9742 (CA-9, 1964)]. The lack-of-knowledge defense has not been upheld by the courts in situations where a person should have known there was a serious risk that withholding taxes were not being paid and where the person was in a position to easily discover the nonpayment (Wright), or in situations where there was a reckless disregard of a known risk that nonpayment occurred (Rem).

The Second Circuit in Rem identified three factual scenarios that would constitute a reckless disregard of a known risk of nonpayment and would result in the willfulness criterion being met. The three scenarios are: 1) “reliance upon the statements of a person in control of the finances when the circumstances show that the responsible person knew the person to be unreliable; 2) failure to investigate or to correct mismanagement after having notice of nonpayment of withholding taxes; and 3) knowing that the business was in financial trouble and continuing to pay other creditors without making reasonable inquiry as to the status of the withholding taxes.”

For example, in Giles v. U.S. [94-2 USTC para. 50607 (CA-7, 1994)], Percy Giles was the volunteer treasurer and ex-officio chairman of the finance and planning committee of Mile Square, a not-for-profit community health clinic. Giles had the opportunity to attend meetings where corporate officers discussed Mile Square’s financial problems, and on occasion he signed checks. He was also responsible for distributing packets to the committee members that detailed Mile Square’s receipts and expenditures. Giles was also an alderman to Chicago’s 37th Ward and worked about 12 hours a day in that capacity. As a result of Giles’ busy schedule, he was unable to attend many board meetings. When he ran the finance committee meetings, he merely followed the agenda prepared by Mile Square’s CEO. Giles claimed that he didn’t know of the unpaid withholding taxes and that he had been too busy to read the financial reports. The court ruled that even if Giles did not know about the failure to pay withholding taxes, it would have been relatively easy for him to discover by simply reviewing the financial reports provided to him. The verdict was upheld on appeal to the Seventh Circuit Court of Appeals.

Several courts have ruled that once a responsible person knows that the individual to whom he has designated responsibility for payment of withholding taxes has failed to pay them in the past, reliance on that person will generally constitute willfulness [e.g., Denbro v. U.S., 93-1 USTC para. 50,177 (CA-10, 1993)]. The Federal Circuit Court of Appeals has applied a more restrictive interpretation, stating that as long as the responsible person ensures that any past failure to make payment has been rectified, he has no affirmative duty to ensure that future payments will be made. In other words, the responsible person must have actual knowledge of a current delinquency to establish a duty to act (Godfrey).

Misconceptions About Collection Procedures

A common misconception about the responsible person penalty is that the IRS must try to recover the unpaid taxes from the company before assessing a penalty against persons within the company. In reality, the responsible persons are both jointly and severally liable. Although the IRS’s policy is to collect only the amount due from any group of jointly liable persons (Internal Revenue Manual, subsection 4784), IRS procedure is to seek a judgment against each party for the full amount due. If more than 100% of the tax is ultimately collected, a refund is issued for the excess. The refund will not be issued until the expiration of the statute of limitations for claims for a refund by the taxpayer, or until the case has been adjudicated. Unfortunately, this process may take several years.

Under IRC section 6672(d), a responsible person who pays more than his share of the trust fund tax penalty has the right to recover the excess from other responsible persons within the company. To facilitate this collection procedure, the person may obtain from the IRS the name of any other person it considers to be liable for the penalty. The IRS must provide information as to whether it has attempted to collect the penalty from that person, the nature of the collection procedures, and the amount collected [IRC section 6103(e)(9)].

As a final note, once a taxpayer is found to be liable for unpaid trust fund taxes, avoidance of payment is virtually impossible. The U.S. Supreme Court has ruled that the liability is nondischargeable in bankruptcy proceedings [U.S. v. Sotelo, 78-1 USTC para. 9446 (USSC, 1978)].

©2009 The New York State Society of CPAs. Legal Notices